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Q3 2023 Independent Bank Corp (Michigan) Earnings Call

Participants

Gavin A. Mohr; CFO, Executive VP, Treasurer & Corporate Secretary; Independent Bank Corporation

Joel F. Rahn; Executive VP of Commercial Lending & Chief Lending Officer; Independent Bank Corporation

William Bradford Kessel; President, CEO & Director; Independent Bank Corporation

Erik Edward Zwick; Director; Hovde Group, LLC, Research Division

Matthew James Renck; Analyst; Keefe, Bruyette, & Woods, Inc., Research Division

Presentation

Operator

Hello all, and welcome to Independent Bank Corporation's Third Quarter 2023 Earnings Call. My name is Lidia, and I'll be your operator today. (Operator Instructions) I'll now hand you over to your host, Brad Kessel, to begin. Please go ahead.

William Bradford Kessel

Good morning, and welcome to today's call. Thank you for joining us for Independent Bank Corporation's conference call and webcast to discuss the company's third quarter 2023 results. I am Brad Kessel, President and Chief Executive Officer, and joining me is Gavin Mohr, Executive Vice President and Chief Financial Officer; and Joel Rahn, Executive Vice President of Commercial Banking for Independent.
Before we begin today's call, I would like to direct you to the important information on Page 2 of our presentation, specifically, the cautionary note regarding forward-looking statements. Anyone who does not already have a copy of the press release issued by us today, you can access it at the company's website, independentbank.com. The agenda for today's call will include prepared remarks followed by a question-and-answer session and then closing remarks.
Independent Bank Corporation reported third quarter 2023 net income of $17.5 million or $0.83 per diluted share versus net income of $17.3 million or $0.81 per diluted share in the prior year period. The increase in the 2023 third quarter results as compared to 2022 is primarily due to a decrease in the provision for credit losses, a decrease in noninterest expense partially offset by a decrease in noninterest income and net interest income and an increase in income tax expense.
For the third quarter of 2023, we generated an annualized return on average assets and return on average equity of 1.34% and 18.68% respectively as compared to 1.40% and 20.48% in the third quarter of 2022. The item most impacting the comparable third quarter 2023 results included the positive changes in fair value due to price of our mortgage servicing rates. $1.6 million or $0.06 per diluted share after tax for the 3-month period ended September 30, '23 as compared to $3.2 million or $0.12 per diluted share after tax for the 3 months ended September 30, 2022.
Our team continued its positive momentum in the third quarter, achieving strong financial results with solid balance sheet growth, a stable net interest margin, disciplined expense management and healthy asset quality. Capitalizing on the current operating environment. We gained new banking relationships with clients who appreciate our value proposition as a leading commercial bank with robust treasury management solutions, industry expertise and client-centric service. This success led to double-digit annualized growth in loans and deposits despite expecting lower loan growth in the fourth quarter due to seasonality. We have a solid pipeline of high-quality relationship opportunities.
With the loan-to-deposit ratio at 82%, we believe we have the capacity to continue to support our ongoing growth of our loan portfolios. We have a very granular deposit portfolio with just 23% of our deposits uninsured. In addition, we have a high level of available liquidity with $2.1 billion in secured borrowing access and borrowing capacity on unpledged securities.
Overall, our deposit base continues to perform well. Total deposits at September 30 were $4.6 billion, up $112.6 million or 10.5% annualized during the third quarter and $206.5 million or 6.3% annualized year-to-date. During this 9-month period, we have seen some level of remixing of our funding as customers take advantage of the interest rate spread opportunities.
Our noninterest-bearing deposits are down $128.1 million, savings and interest-bearing checking are down $43.4 million, reciprocal deposits are up $197.3 million and time deposits are up $156.4 million while brokered time deposits are up $24.3 million. This past quarter, while continuing to see some remixing of the deposit base, the pace significantly slowed with noninterest-bearing deposits declining by $13.9 million or 4.8% annualized during the third quarter.
We have included in our presentation a historical view of our cost of funds as compared to the Fed fund spot rate and Fed effective rate for the quarter. Our total cost of funds increased by 23 basis points to 1.80%. Through the third quarter, the cumulative cycle beta for our cost of funds is now at 32.6%. At this time, I would like to turn the presentation over to Joel Rahn to share a few comments on the success we are having in growing our loan portfolios and provide an update on our credit metrics.

Joel F. Rahn

Thanks, Brad. I'll start on Page 7, where we provide an update on our well-diversified loan portfolio. Total loans increased $110 million in the third quarter. Strongest segment was -- in the quarter was commercial lending, growing by $88 million. We also realized growth in our mortgage business with that portfolio growing by $34 million. Our installment portfolio experienced a $12 million decline in the quarter as we have strategically pulled back in that area. We continue to see the return on our strategic investment and the expansion of our commercial banking team.
The experienced talent that we've added over the past 24 months has been a strong contributor to our commercial growth, which on an annualized basis was 14.5% through the third quarter. Looking forward, based upon a strong pipeline and solid liquidity position, we see continued growth opportunity while maintaining our disciplined credit standards.
Page 8 provides detail on our commercial loan portfolio. As I've indicated in prior quarters, C&I lending continues to be our primary focus, representing 64% of the portfolio. Manufacturing continues to be the largest segment within the C&I segment, comprising approximately 9% or $149 million. The remaining 36% of the portfolio is comprised of commercial real estate with the largest concentrations being industrial at $157 million or 10.2% and retail at $136 million or 8.9%. It's worth noting that our exposure to the office segment stands at $93 million or 6.1% of our commercial portfolio at quarter end.
Our office exposure consists primarily of suburban, low-rise office space, and medical comprises 25% of our overall office exposure. This particular segment of our portfolio continues to perform very well. For additional insight into our office exposure, I refer you to the appendix of this presentation.
Page 9 provides an overview of key credit quality metrics at 9/30. Overall credit quality continues to be excellent. Total nonperforming loans were $4.7 million or 1.2% of total loans at quarter end. Loans 30 to 89 days delinquent totaled $4.9 million or 0.13% at 9/30, which is consistent with last quarter end.
At this time, I'd like to turn the presentation over to Gavin for his comments, including the outlook for the remainder of the year.

Gavin A. Mohr

Thanks, Joel, and good morning, everyone. I am starting at Page 10 of our presentation. Page 10 highlights our strong regulatory capital position. All capital ratios were stable from the linked quarter. Net interest income decreased $0.5 million from the year ago period. Our tax equivalent net interest margin was 3.25% during the third quarter of 2023 compared to 3.49% in the third quarter of 2022 and down 1 basis point from the second quarter of 2023. Average interest-earning assets were $4.89 billion in the third quarter of 2023 compared to $4.61 billion in the year ago quarter and $4.76 billion in the second quarter of 2023. Page 12 contains a more detailed analysis of the linked quarter decrease in net interest income and the net interest margin.
On a linked quarter basis, our third quarter 2023 net interest margin was positively impacted by 2 factors: increase in yield on loans and investments of 16 basis points and a change in earning asset mix of 5 basis points. These increases were offset by an increase in funding costs of 19 basis points and 3 basis points that were due to changes in funding mix. We will comment more specifically on our outlook for net interest income and the net interest margin for 2023 later in the presentation.
On Page 13, we provide details on the institution's interest rate risk position, the comparative simulation analysis for the third quarter of '23 and the second quarter of '23 calculates the change in net interest income over the next 12 months under 5 rate scenarios. All scenarios assumed a strategic static balance sheet. The base rate scenario applies the spot yield curve from the valuation date. The shock scenarios consider immediate, permanent and parallel rate changes.
The increase in the base rate forecasted net interest income in the third quarter '23 compared to the second quarter of '23 is primarily due to an improvement in asset mix with an increase in loans and a decline in investments along with a slight benefit from higher rates. Sensitivity is largely unchanged during the quarter with the exposure to rising rates declining modestly from larger rate increases. Currently, 32% of assets reprice in 1 month and 44.2% reprice in the next 12 months.
Moving on to Page 14. Noninterest income totaled $15.6 million in the third quarter of 2023 as compared to $16.9 million in the year ago quarter and $15.4 million in the second quarter of '23. Third quarter '23 net gains on mortgage loans totaled $2.1 million compared to $2.9 million in the third quarter of '22. The decrease is primarily due to lower mortgage loan sales volume that were partially offset by increased profit margins and fair value adjustments. Positively impacting noninterest income was $2.7 million of mortgage loan servicing income. This is comprised of $2.2 million of revenue and $1.6 million or $0.06 per diluted share after tax increase in the fair value due to price. That's partially offset by a $1.1 million decrease due to pay downs of capitalized mortgage loans servicing rates in the third quarter of 2023.
As detailed on Page 15, our noninterest expense totaled $32 million in the third quarter of 2023 as compared to $32.4 million in the year ago quarter and $32.2 million in the second quarter of 2023. Compensation increased $0.2 million compared to the prior year quarter due to raises that were effective at the start of the year and a decreased level of compensation that was deferred in the third quarter of 2023 as direct origination costs on lower mortgage loan origination volume.
Performance-based compensation decreased $1.3 million due primarily to lower expected incentive compensation payout for salary and hourly employees and a decrease in mortgage lending related to incentives attributed to decline in mortgage lending compared to third quarter. Data processing costs increased by $0.4 million from the prior year period, primarily due to coordinated processors, annual asset growth and CPI-related cost increases, lower net mortgage process-related cost deferrals due to lower mortgage loan volume as well as prior year-to-date period -- as well as the purchase of a new lending solution software in 2023.
Page 16 is our update for our 2023 outlook to see how our actual performance during the third quarter compared to the original outlook that was provided in January 2023. Our outlook estimated loan growth in the low double digits, loans increased $110.4 million in the third quarter of 2023 or 12.1% annualized, which is above our forecasted range. Commercial and mortgage had positive growth, while installment loans decreased slightly in the third quarter of '23. Third quarter 2023 net interest income decreased by 1.2% over 2022, which is lower than our forecast of high single-digit growth.
The net interest margin was 3.25% for the current quarter and 3.49% for the prior year quarter. The third quarter '23 net interest income was below our original forecast. The third quarter 2023 provision for credit losses was an expense of $1.4 million or 0.15% annualized, the third quarter '23 provision expense was primarily the result of loan growth and a decrease in prepayment speeds, primarily related to jumbo mortgages. The provision expense related to loans in the third quarter of '23 was lower than our forecasted range.
Moving on to Page 17. Noninterest income totaled $15.6 million in the third quarter, which was higher than our forecasted range of $11 million to $13 million. Third quarter '23 mortgage loan originations, sales and gains totaled $172.9 million, $115.3 million and $2 million, respectively. Mortgage loan servicing that generated income of $2.7 million in the third quarter of '23.
Noninterest expense was $32 million in the third quarter within our forecasted range of $32 million to $33.5 million targeted quarterly. Our effective tax income tax rate of 19% for the third quarter of 2023, which was a little higher than our forecast. Lastly, 88,401 shares were repurchased in the third quarter of '23 at an average share price of $19.15. Year-to-date, 288,401 shares have been repurchased at an average share price of $17.21. That concludes my prepared remarks, and I would now like to turn the call back over to Brad.

William Bradford Kessel

Thanks, Gavin. These strong results, which our company has been delivering quarter over quarter year after year for some time is directly attributable to our talented team, their focus on personalized service, investing in our communities and making banking easy. Our financial results once again gained us nice recognition in being named one of 31 banks and thrifts that comprise Piper Sandler's Sm-All Stars Class of 2023.
Our team is very proud of this recognition. We intend to finish 2023 strong with our focus continuing to be on investing in our team, leveraging our technology and supporting our communities. In doing so, we will continue the rotation of earning assets out of lower-yielding investments into higher-yielding loans. With the strong value proposition offered as a leading commercial bank, we believe we can continue to grow our deposit base while managing our cost of funds and controlling our noninterest expenses. Accordingly, we are excited about the opportunities we have to continue our growth trends. We've built a strong franchise, which positions us well to effectively manage through a variety of economic environments and continue delivering strong and consistent results for our shareholders. At this point, we would now like to open up the call for questions.

Question and Answer Session

Operator

(Operator Instructions) Our first question today comes from Erik Zwick of Hovde Group.

Erik Edward Zwick

I wanted to first start -- wanted to first start on, I guess, kind of the loan growth and your comments about fourth quarter likely to be a little bit slower due to seasonality, but the pipeline is still very strong. So I expect that to start to pick up again in the beginning of next year. Wondering, if you could just add a little commentary on towards the mix of the pipeline where you're seeing strength today from kind of a product type and maybe industry as well?

Joel F. Rahn

Yes. This is Joel. On the pipeline, it is still very solid as we head into the fourth quarter. And of course, commercial pipeline tends to be pretty long. So that will take us into the early part of next year. It really is a pretty diverse mix. I really can't point to any one area that is stronger. We're seeing growth in -- C&I, again, is our primary focus.
And we are seeing those opportunities. We've seen good opportunity in medical-related space interestingly enough, and that's again because of long-term relationships that our bankers have had in the community. And some select commercial real estate, primarily industrial has been a focus for us right now. So that would be just some additional color from my vantage point .

Erik Edward Zwick

I appreciate that. And then you mentioned you've strategically pulled back from the installment portfolio. Just curious, if you could add maybe a bit of additional commentary there. Is that you're just seeing better opportunities in other areas? Or is it kind of a cautionary stance due to just kind of uncertain economic outlook? Or just curious how you're thinking about that portfolio today.

William Bradford Kessel

Yes. Erik, that's a great question. I think it's twofold. I think number one is, we are really excited about the continued demand for our commercial banking team in our markets. And we like that asset class, the yields, the risk profile that go with it. And so I think that's one just we had to prioritize our capital allocation. It goes in that direction. I think the second piece is, we're watching closely the consumer. There's a lot written about slowdown in the consumer itself driving its savings -- their savings level declining. And also, I think -- so that's the second aspect, just being cognizant of what's happening with the consumer.
And then third, our consumer installment area historically is driven out of production, direct out of our branches and then our indirect channel, which is marine and RV. And I'd say, we are a little more cautious on the RV side of it. I think there was a pretty strong run up during the pandemic. And so we are watching those collateral values closely. Hopefully, that helps.

Erik Edward Zwick

Yes, Very helpful. And one last one for me. Just looking at -- thinking about expenses at the bottom of figure, what the slide #1 has put up, had some commentary about expenses, and you mentioned opportunities exist for additional efficiencies as you optimize delivery channels and then on Slide 18, you have a list of, I guess, kind of target areas for process improvements and cost control.
So I'm just kind of curious as we think about looking into '24, even kind of what the biggest opportunities are to keep expenses under control. And do you have a kind of target in mind for the efficiency ratio or just generally targeting additional improvement over time?

William Bradford Kessel

So another great question. I'd say, first off, I'm really pleased with the very positive trending of our efficiency ratio both on a 4-quarter basis, but just really over time, year after year. And we've taken it from the 70s through the 60s, and now we're in the high 50s, and we think that we continue to positively reduce that.
And first and foremost, I would point to our core conversion, which we pulled the switch in May of 2021. And we continue to see opportunities just to efficiencies with all the different technologies that's interrelated and connected. And so I think there's opportunities in the back room. And then I would point over towards our branch footprint, and we continue to look at ways to optimize there.
We are well underway in the use of teller recycler machines, which we see significant opportunities and throughout the whole footprint. So those are a couple of examples. And obviously, every area is charged with just how do we get better, how do we get smarter, how do we have less touches, how do we better serve the customer. And so I'm really excited about. I think there is room for us to continue to improve.

Operator

(Operator Instructions) Our next question comes from Damon DelMonte of KBW.

Matthew James Renck

This is Matt Renck filling in for Damon DelMonte. I hope everybody is doing good today. My first question was, are there any potential impacts from the UAW strike on your business? And do you think it could drive provision higher if the local economy start to suffer?

William Bradford Kessel

So Matt, thanks for the call. And I think, obviously, hey, we're in Michigan and it's in our footprint. But I want to -- let's start off with the commercial side to it. And Joel, you've been speaking with our team and with our customer base, can give us an update there.

Joel F. Rahn

Yes. Of course, the big unknown is how long the strike lasts. So that's the big qualifier. But we've been in regular contact with the customers that we have that would be directly impacted. Fortunately, in our portfolio, it's really a pretty small percentage of our customer base in our portfolio. So we've got [6] customers that would have direct impact from the strike, that's about $60 million in total outstandings today or about 3.5% of our portfolio so just to put that in perspective. So we're not -- again, our portfolio is very well diversified, and we're not real heavy in automotive supply.
And we're talking to those customers on a weekly basis. So far, the strike impact is phenomenal. But as it continues to drag on, at some point, it will affect the -- even these Tier 2 suppliers, and they would be forced to lay people off. So we have not seen that yet.

William Bradford Kessel

Yes. And I would just add then -- Yes, Matt, I would just add then you carry over to the consumer portfolio, and we've had just minimally less than you can count on one hand inquiries from the customer base in terms of, hey, if the strike continues, can you work with me. So it's been very small and has not meaningfully impacted our performance metrics up to this point.

Matthew James Renck

Okay. Great. And I don't know, if you can share it, but is there a point in time that the strike reaches that's like in your mind that's when the trouble starts. Is it midway through next year? Is It through the end of this year? If you could share that.

Joel F. Rahn

That's really hard to quantify. If I had to just provide my personal opinion on when it would start to affect -- ripple down into the supply base, it's going to be soon, I mean, within the next, I mean, 30 to 45 days. When we initially talked to our customers at the very front end of the strike, which was back in mid-September, the general consensus was we're fine for a month to 6 weeks. But if it drags on longer than that, it will start to affect our production. So I think it's sooner rather than later, but we're all just hoping that the strike is resolved here in the next 30 to 60 days.

Matthew James Renck

Okay. Great. And then one last question from me. Just on the securities portfolio, could you remind us, do you have a targeted percentage of earning assets you want to work that down to or maintain?

Gavin A. Mohr

Yes. So 12% to 15% would be the target, and we will just -- we'll evaluate as we move down to that ratio based on the broader liquidity profile of the bank.

Operator

We have no further questions on the call at this time. So I'll turn the call back over to you, Brad, for closing remarks.

William Bradford Kessel

Thank you, Lidia. In closing, I would like to thank our Board of Directors and our senior management for their support and leadership. I also want to thank all of our associates. I continue to be so proud of the job being done by each member of our team. Each team member in his or her own way continues to do their part towards our common goal of guiding our customers to the Independent. Finally, I'd like to thank each of you for your interest in Independent Bank Corporation and for joining us on today's call. Have a great day.

Operator

This concludes today's call. Thank you for joining. You may now disconnect your lines.

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